LECTURE: STATEMENT OF

CASH FLOW II LECTURE A

Differentiate between profit and cash flow

Difference between

Profit Cash flow

is obtained after deducting
all expenses including non – cash is obtained after adding
expenses non – cash expenses to profit

& adding all income including & deducting non – cash incomes
non – cash incomes from profit
Understand the need for management to control cash flow

The need for statement of cash flows:

 Cash finances the day–to–day operations

 Survival depends upon cash generating ability
 Creditors and bankers determine creditworthiness based upon cash flows
 In order to obtain an optimal balance between profitability & liquidity

Balance between profitability and liquidity

Management has to strike a balance

Decrease in Profitability
Increase in profitability

Increase in liquidity
Decrease in liquidity

Leads
Leads
to
to

Profitability Liquidity
Important Definitions

Cash – “Cash comprises cash in hand and demand deposits”

Cash equivalents – “Cash equivalents are short-term, highly liquid investments that are
readily convertible to known amounts of cash and which are subject to an insignificant
risk of changes in value”

Example

 Preference shares acquired within a short period (3 months) from their maturity may be treated
as cash equivalents.

 Bank overdrafts repayable on demand are treated as part of cash equivalents

General principles of the classification of cash flows

According to IAS 7, the cash flows should be classified in the following

standard headings:

Operating Investing
Financing activities
activities activities
Operating Activities

Users can judge whether the purpose

of entity’s existence is fulfilled

Examples

 Cash flows from operating activities

 Cash receipts from the sale of goods and the rendering of services
 Cash receipts from royalties, fees, commission and other revenue
Investing and Financing Activities

Examples of cash flows from investing activities

 Property, plant and equipment, intangibles and other long-term assets e.g. acquisition or
disposal of equipment
 If money is invested in new machinery, it will help the entity to produce and sell more goods,
which in turn will generate more income in the future.

Examples of cash flows from financing activities

 Issue or redemption of shares
 Borrowing and repayment of debentures, loans, notes, bonds, mortgages and other short or long-
term borrowings
Classification of Certain Specific Items

Item Classification
Interest paid  Either under operating activity since paid out of revenues from operations or
 Financing activity since it represents the cost of obtaining a financial
resource
Interest  Investment activity if it represents return on investments or
received  Operating activity
Dividend  Investment activity if it represents return on investments or
received  Operating activity
Dividend paid  Financing activity if it represents the cost of obtaining a financial resource or
 Operating activity if paid out of revenues from operations
Income taxes  Operating activities unless they can be specifically identified with financing &
investing activity
Sale of non –  Should not be classified as an operating activity but as an investing activity
current asset
Test Yourself 4 (Refer Page 502)

Identify the classification of the following activities in order to prepare a statement of cash flows.
A. Issue of share capital for cash
B. Issue of share capital other than cash, for acquisition of business
C. Payment to suppliers
D. Depreciation
E. Purchase of a plant
F. Dividend paid
G. Taxes on income
Answer
A. Financing activities
B. Not a cash flow item, although needs a separate disclosure
C. Operating activities
D. It is a non-cash item. Not included in the cash flow. In the indirect method, it is added back since
the starting net profit is after depreciation.
E. Investing activities
F. Either as a finance activity or as an operating activity. (The IAS allows flexibility to the entities to
decide how to classify interest and dividends, depending upon circumstances and the judgement
of management).
G. Operating activities, unless they can be specifically identified with financing and investing
activities.
 The direct method shows each major class of gross cash receipts and gross cash
payments. The operating cash flows section of the statement of cash flows under
the direct method would appear something like this:

Cash receipts from customers xx,xxx

Cash paid to suppliers (xx,xxx)
Cash paid to employees (xx,xxx)
Cash paid for other operating expenses (xx,xxx)
Interest paid (xx,xxx)
Income taxes paid (xx,xxx)
Net cash from operating activities xx,xxx
Prepare extracts from a Statement of Cash Flows

Cash flow from operating activities – direct method

Example (Refer Page 509)

From the following details of Lilly Co, calculate the cash flow from operating activities, using the direct
method:
$
Opening balance of trade receivables 575,000
Credit sales 4,910,500
Closing balance of trade receivables 655,500
Cash paid to employees 690,000
Opening balance of trade payables 345,000
Credit purchases 3,737,500
Closing balance of trade payables 402,500
Interest paid 230,000
Income taxes paid 287,500
Answer

Cash flows from the operating activities for the year ended 31 March 20X6
$
Cash receipts from customers (W1) 4,830,000
Cash paid to suppliers (W2) (3,680,000)
Cash paid to employees (690,000)
Cash generated from operations 460,000
Interest paid (230,000)
Income taxes paid (287,500)
Net cash from operating activities (57,500)
Workings W1 Receivables account
$ $
Cash received (balancing figure)
Balance brought forward 575,000 *4,830,000
(5,485,500 – 655,500)
Credit sales 4,910,500 Balance carried forward 655,500
  5,485,500   5,485,500
W2 Cash paid to suppliers Payables account
$ $
Cash paid (balancing figure) *3,680,000 Balance b/f 345,000
Balance carried forward 402,500 Credit purchases 3,737,500
  4,082,500   4,082,500
Changes in Working Capital

Trade receivables Trade receivables

Or Or
Inventory Inventory

Inflow of cash
Outflow of cash

Entity
Inflow of cash Outflow of cash

Trade payables Trade payables

 The indirect method adjusts accrual basis net profit or loss for the effects of non-
cash transactions. The operating cash flows section of the statement of cash flows
under the indirect method would appear something like this:

Profit before interest and income taxes xx,xxx

Add back depreciation xx,xxx
Add back amortisation of goodwill xx,xxx
Increase in receivables (xx,xxx)
Decrease in inventories xx,xxx
Increase in trade payables xx,xxx
xx,
Interest expense
xxx
xx,
Less Interest accrued but not yet paid
xxx
Interest paid (xx,xxx)
Income taxes paid (xx,xxx)
Net cash from operating activities xx,xxx
Cash flow from operating activities – Indirect method

Example (Refer Page 510)

Thomson provides the following details

Profit before tax for the year 200,000

Depreciation 40,000

Profit on sale of fixed assets 15,000

Investment income 10,000

Interest expense 100,000

Decrease in trade receivables 30,000

Increase in inventories 55,000

Increase in trade payable 18,000

DetermineIncome
the cashtaxes
flow from
paid operating activities using indirect method 25,000
Answer

Cash flows from operating activities

$
Profit before taxation 200,000
Adjustments for:

Depreciation 40,000

Profit on sale of fixed assets (15,000)

Investment income (10,000)
215,000
Decrease in trade receivables 30,000
Increase in inventories (55,000)
Increase in trade payable 18,000
Cash generated from operations 208,000
Income taxes paid (25,000)
Net cash from operating activities 183,000
SEQ 4

From the following information calculate the cash flow from operating activities:
Profit before depreciation was $100,000

Balances 01/01/20X6 31/12/20X6

Non-current assets 90,000 65,000
Inventories 63,000 27,000
Debtors 58,000 45,000
Cash in bank 12,000 6,500
Creditors 35,000 30,000
Share capital 220,000 120,000

There is no addition or deduction in the non-current assets during the period.

A. $56,000
B. $(56,000)
C. $1,44,000
D. $(1,44,000)
Answer

Cash flow from operating activity

Profit before depreciation 100,000

Inventories (63,000 - 27,000) 36,000

Debtors (58,000 - 45,000) 13,000

Creditors (35000 - 30000) (5,000)

Net cash flow from operating activities 144,000

Test Yourself 5 (Refer Page 504)

For the following information determine the cash flow from investing activities.
1)Sale of building: carrying value $280,000 at a profit of $38,000
2)Sale of long-term investment: carrying amount $340,000 at a loss of $17,000
3)Purchase of car for $540,000 out of which $300,000 is outstanding
4)Interest paid: $45,000

A. $401,000
B. $356,000
C. $701,000
D. $641,000
Answer
The correct option is A.
Cash flow from Investing Activities $
Sale of building (280,000 + 38,000) 318,000
Sale of long-term investment (340,000 - 17,000) 323,000
Purchase of car (540,000 - 300,000) (240,000)
------------------
Net cash flow from investing activities 401,000
Interest paid will come under the financing activities
Test Yourself 3 (Refer Page 497)

Which of the following are the drawbacks of preparing statement of cash flows?

A. A statement of cash flows is prepared on a cash basis. It does not match the related inflows
and outflows of expenses on the basis of accrual.
B. It is difficult to understand for a person who does not have a technical knowledge of
accounting.
C. It does not facilitate the comparability of the operating performance of two entities or two
periods.
D. None of the above

Answer

The correct option is A.

This is a drawback of the statement of cash flows because it ignores the matching principle that
is based on accruals. Options (b) and (c) are not drawbacks of the statement of cash flows is
simple to understand. Even a person who doesn’t have an in-depth knowledge of accounting
can understand the cash flows. It facilitates the comparability between two entities or two
periods.
Cash flow from investing activities

Example

Purchase of new furniture and fixtures $180,000

Installation charges for the furniture $15,000

Sale of old furniture and fixtures at a loss of $21,000 (carrying value $85,000)

Purchase of a building worth $720,000 for which $100,000 advance was paid
last year and remainder is paid by taking loan from City bank.

Amount invested in long-term investments $175,000

Dividend paid $35,000
Dividend received $25,000

Find out cash flow from investing activities.

Answer

Cash flow from investing activities $

Purchase of property and furniture and fixtures (W1) (815,000)
Proceeds from sale of furniture and fixtures ($85,000-$21,000) 64,000
Long-term investment (175,000)
Dividend received 25,000
Net cash used in investing activities (901,000)

W1 Purchase of property and furniture and fixtures

$ $
Cost of building 720,000
Less: advance paid last year 100,000 620,000

Furniture and fixtures 180,000

Add: installation charges 15,000 195,000
815,000
Note
Dividend paid is a financing activity
Loan from bank is a financing activity
Cash flow from financing activities

Example

Ideal Inc gives you the following information. You are required to calculate the cash flow from the
financing activities.
$

Issue of 5% debentures at 2% discount 300,000

(Nominal value)
Issue of 15,000 shares for cash of $10 each at 5% premium 150,000
(Nominal value)

Repayment of loan including interest $80,000 120,000

Dividend paid 60,000
Answer

Cash flows from financing activities $

Proceeds from issue of debentures (W2) 294,000
Proceeds from issue of share capital (W1) 157,500
Term loan repayments (120,000)
Dividends paid (60,000)
Net cash flows from financing activities 271,500
Workings

W1 Issue of share capital

$
Nominal value 150,000
5% premium 7,500
157,500

W2 Issue of Debentures
$
Nominal value 300,000
2% Discount 6,000
294,000
Example

The following information relates to Poly Plc. Calculate the cash flow from financing and investing
activities of Poly Plc for the year to 31 August 20X9.
$
Purchase of a plot of land 150,000
(out of the purchase price, $50,000 is outstanding
and advance paid in the last accounting year is $20,000)
Sale of vehicle (book value of $92,000) 85,000
Depreciation charged during the year on non-current assets 53,000
Dividend received 156,000
Interest on the deposit in bank received 45,000
Dividend paid 50,000
Obtained loan from bank 200,000
Long-term investment in bank 250,000

Additional information
A. Sale of long-term investments with a carrying amount of $120,000 at a loss of $25,000
B. The loan $20,000 is repaid (out of this, $12,000 is paid for interest)
C. Issued 100,000 ordinary shares for cash of $5 each at premium $1
Answer

Cash flow from Investing Activities

Inflow $
Sale of vehicle 85,000
Dividend received 156,000
Interest received 45,000
Sale of investment (120,000 - 25000) 95,000
Purchase of plot of land(150,000 - 20,000 - 50,000) (80,000)
Purchase of long term investment (250,000)
Net cash flow from investing activities 51,000

Cash flow from financing activities

Issue of shares 600,000
Loan from bank 200,000
Repayment of loan* (20,000)
Dividend paid (50,000)
Net cash flow from investing activities 730,000

*Interest payment is treated as a financing activity. Alternatively, it may be presented under

operating activities